JakilaTheHun (99.93)

CPI, Housing Prices, and The Great Stagflation

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Back in April, Floyd Norris of the New York Times wrote one of the most insightful articles I have encountered all year. He decided to look at CPI if home prices continued to be included in the index after 1983. This, of course, requires a little bit of explanation.

Prior to 1983, the US Consumer Price Index included housing prices. A change was made at that time, however, to replace housing prices with a concept called “owners’ equivalent rent.” The rationale behind this change was that CPI should not include “investments” and home ownership was both consumption and investment. “Owners’ equivalent rent” was measured not by housing prices, but by rental prices given up by the homeowner in order to occupy the unit. In this way, it was hoped to strip out the “investment” related aspect of housing, while still holding onto the consumption aspect of it.

Unfortunately, this minor change in the way CPI was measured has had dramatic results on the end product. It’s created a situation where the Federal Reserve and other government actors are looking at one set of statistics to measure inflation, when the economic reality can be completely different. This is not to suggest that there is a conspiracy to engineer the statistics, as some have argued. Rather, a minor change in methodology has merely changed the way we perceive things in a detrimental fashion.

Alternative Economics

I’ve become enamored by how the disparity between official economic statistics and economic reality might have caused poor decision making by both the public sector and the private sector. As a result, I’ve launched a website, Alternative Economics, dedicated to exploring this issue in more detail. The centerpiece of my efforts is an Alternative CPI measure based on housing prices. From this, I’ve also re-examined GDP growth and monetary policy. The results have been paradigm-shifting, to say the least.

After viewing the economy under the lens of “Alternative CPI”, the US appears to have had negative real economic growth from 2000 to 2006. With high nominal GDP growth offset by even higher inflation, this period would be most properly termed “The Great Stagflation” or alternatively, “The Great Inflationary Depression.”

In this sense, 2000 – 2006 was the worst period in American economic history since the Great Depression and the ‘70s Stagflationary Era. While I’ve drawn several conclusions using my data, for now, I want to focus on my concept of Alternative CPI to show you why it’s more accurate and why it should change the way you think about the Aughts.

Alternative CPI Methodology

One major reason why housing price data is vital for any realistic inflation measure in the United States is because so much of American consumption is related to housing. Roughly 65% of Americans are homeowners and we have a society that views home ownership as an important goal in life. Mortgage payments often make up anywhere from 25% – 40% of monthly income for many Americans, making it a major cost.

Due to the effect of leverage in the housing market, it is one of the areas of consumer expenditure where prices are most likely to become inflated due to an excess supply of money. Given this, to ignore housing prices in inflationary measures is pure folly. Indeed, what’s the point of even examining CPI inflation if it ignores the most pertinent item in most American’s budgets?

For my conception of Alternative CPI, I’ve replaced the BLS’s concept of owners’ equivalent rent, with the S&P /Case-Shiller Home Price Index. This is slightly different than Floyd Norris’ conception in the NY Times, as he uses statistics compiled from Fannie Mae and Freddie Mac. I decided to use Case-Shiller over this for a few reasons, including greater ease of access. Moreover, I would view it as an acceptable proxy for housing prices across the country.

In spite of the fact that urban housing prices would tend to rise more in a boom than rural prices, the majority of the American populace lives in a major metropolitan area. Urban housing prices would also be a better indicator of dangers in the real economy.

With Case-Shiller, there is both a 10-city index and a 20-city index. The 10-city index has a longer history, going back to 1987, while the 20-city index only reaches back to 2000. The obvious advantage with the 20-city index is that it looks at a broader swath of housing data. However, in practice, the two indexes do not dramatically differ from one another, as the chart below suggests:

While the Case-Shiller 10-city index does show slightly higher year-over-year increases during the housing boom years, the differences are not that dramatic. In fact, if we take the above chart and add the BLS’s concept of “Owners’ Equivalent Rent” [OER], you will quickly see that the differences between the two Case-Shiller indices are minor compared to the difference between Case-Shiller housing price data and “Owners’ Equivalent Rent.”

Given this, I decided to use Case-Shiller’s 10-city housing price index in order to calculate Alternative CPI. The longer history associated with that index creates a better data set and it’s not a stretch to suggest that the Case-10 can serve as a proxy for a broader metropolitan housing market index.

Before jumping to the results of our Alternative CPI, let’s take a look at one final chart examining the Case-Shiller Index versus owners’ equivalent rent. The chart below shows the index values, as opposed to year-over-year increases as in the chart above. The giant hill in the chart represents the housing bubble and you can see that we are just now reaching a point where the Case-Shiller 10-city index and OER are finally close to one another again:

Alternative CPI

Due to the failure of OER to capture true price inflation, it’s easy to see why Alternative CPI ends up being such an important concept. OER allowed official inflation figures to be dramatically understated for years and might have hidden major economic problems in the United States during the early ‘00s. Moreover, it led to extremely poor policymaking from the Federal Reserve and the US government.

Let’s examine how Alternative CPI differs from official CPI. For my measure, I did not change any inputs in official CPI inflation except OER, which I replaced with the Case-Shiller 10-city housing price index. With this one minor change, CPI looks dramatically different as the chart below shows:

Official CPI and Alternative CPI stay within about a 200 basis point spread of one another from 1988 to 1998. After that, the two figures start to drift apart considerably. By 2004, there is nearly a 700 basis point spread between official CPI and our Alternative CPI measure.

In July ’04, for instance, official CPI records a mild 3.0% year-over-year increase in inflation. While this is lower than the Federal Reserve’s general target, it’s not all that alarming, all the same. 3% is well within US historical averages during healthy economic times.

Alternative CPI, on the other hand, reports a troubling 9.4% year-over-year increase in inflation. If official CPI had reported such a high result, alarm bells would’ve been set off all over the place. 3% is manageable inflation; 9.4% suggests an economy with major problems. In fact, we had already drifted over 6% inflation in 1999 using my Alternative CPI gauge; and after the tech crash, we eclipsed 6% inflation once again by mid-2002.

Alternative Real GDP

Where this becomes even more profound is when we start looking at the Alternative CPI inflation compared with economic growth and monetary policy. I’m saving the monetary policy discussion for my next article, so for now, we’ll focus on economic growth. This is where our Alternative CPI starts to become “paradigm-shifting.” The chart below examines Alternative CPI versus Nominal GDP:

The best way to read the chart above is to examine both lines to see which one is on top. When the blue line is above the red line, that means that the US was experiencing positive real economic growth. When the blue line is below the red line, that means that price increases were outpacing nominal GDP growth, so that real economic growth was negative. Notice that the 2000 to 2006 period does not look all that terribly great under this prism.

Now, to make things a bit more clear, here is the data from the chart above reproduced into one Alternative Real GDP measure.

As you can see, from this perspective of the two charts above, the ‘90s was an era of great economic prosperity with positive growth almost the entire decade. Once we drift into the ‘00s, however, we have continued negative economic growth from 2000 till 2006. At that point, dramatic falls in housing prices lowered the real cost of living, thereby creating real economic gains.

In fact, surprisingly, according to this conceptualization, we’ve had more real economic growth from 2006 to 2011 than we did from 2000 to 2006. This isn’t because the US economy was doing exceptionally well in the latter period so much as the drop in real estate prices allowed for sustainable economic growth to resume; albeit, with a huge overhang from a weakened banking system holding things back a bit and stifling employment.

Hence, from this perspective of Alternative CPI inflation, the first half of the ‘00s appears as if it would be more aptly called “the Great Stagflation.” It should not be perceived as a period of prosperity, but rather, an inflationary depression, caused by poor monetary policy, misguided housing incentives, and an unneeded stimulus from the Federal government that only made things worse.

The Great Stagflation

Looking back, this period should have never been considered a “boom period” at all. Rather, it may have been the classic case of demand-pull inflation. In demand-pull inflation, unemployment actually falls below the “full employment” level, so laborers demand significantly higher wages. Unfortunately the small increases in productivity at this level (i.e. aggregate supply) are outpaced by increases in aggregate demand. This drives up end prices, resulting in inflation.

As such, the Great Stagflation should be examined as a more than just a boom; but actually, a depressionary boom, where an oversupply of money in the economy created a situation where the overall economy was experiencing negative returns on investment.

From 2006 onwards, we’ve been dealing only with the aftermath, but economically, things have actually improved significantly, now that housing and real estate has become more affordable. But what caused the Great Stagflation?

In my next article, we’ll examine monetary policy and how it helped contributed to the Great Stagflation.

It's true that the official numbers don't account for the true rise in home prices... but I think you have written off their explanation a bit too quickly. Their desire to leave out the "investment" part of housing is valid, in my view. They may have just gone about it in a flawed way.

My take is that the true level of inflation should be somewhere between your numbers and the official stats. It would be interesting to see if we could take your numbers and make a small adjustment to account for the increase in household "wealth" or "purchasing power" that resulted from the increase in home values.

If someone bought a home 30 years ago and they still own it today, then this "inflation" of home prices has benefitted them (or at least, it will benefit them whenever they sell the house). My point is simply that some people have more wealth as a result of higher housing prices, and this needs to be accounted for in some way.

Uhh...That's not a myth. Unless you think miles and miles of Soup Lines means we have an awesome economy.

You can not strip out employment from the overall assessment of an economy's health. Not until we come up with how in the heck do people put food on the table if everything is being handled by E-Readers, and Robots.

You have discovered that the 2000s were not real growth, but instead an illusion of growth due to monetary expansion (i.e. classical inflation.) There were actually many smart people saying this very thing throughout the decade. You have in the past called them all sorts of interesting names.

The bust was inevitable and predictable. And they predicted it.

Low unemployment is a healthy economy, as long as that employment is directed by consumer choice, and not by artificially low interest rates that distort prices and direct resources to areas where they would otherwise not be profitable.

I strongly recommend you follow this post up with some words of wisdom from F.A. Hayek. As he predicted, high unemployment is the certain result of an inflation fueled bubble (or great stagflation if you prefer), and attempting to keep people in their current job irrespective of consumer choice, once the bubble bursts can only bring about more pain.

You never respond to my criticisms, even when they aren't criticisms, so I'll just leave this for others.

And no, I won't be responding to ideological attacks from the usual suspects either.

"Low unemployment is a healthy economy, as long as that employment is directed by consumer choice, and not by artificially low interest rates "

"And no, I won't be responding to ideological attacks from the usual suspects either."

Thanks for responding to my post inspite of saying that you won't respond to my post because I am an "Ideological attack" or something. I gave your post a +1 rec.

I don't do "ideological attacks" though. I just present issues of concern when I read your post.

Take it to mean I found very little to disagree with other than you statement that a healthy economy can have high unemployment. Employment, to me, is the focal point of assessing the health of any economy.

I prefer not worry about how you got the good employment and more about making sure it stays. Even under your best scenario for creating a solid economy, a poor education system along with international competition can still destroy it.

The statement about ideological attacks wasn't directed at you. Nor do I disagree with you. I just felt like cleaning up both points on the unemployment question, since they were both off base as they stood.

"While traveling by car [in China] during one of his many overseas travels, Professor Milton Friedman spotted scores of road builders moving earth with shovels instead of modern machinery. When he asked why powerful equipment wasn’t used instead of so many laborers, his host told him it was to keep employment high in the construction industry. If they used tractors or modern road building equipment, fewer people would have jobs was his host’s logic

Then instead of shovels, why don’t you give them spoons and create even more jobs?” Friedman inquired.

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Employment is a much more complex subject than people make it out to be. High unemployment is rarely a good thing. However, low unemployment isn't automatically a beneficial thing, either. We could easily lower unemployment to 3% if we wanted to by enacting a government program to employ people to clean windows of Federal buildings with toothbrushes. That wouldn't actually increase productivity any, however. It would simply be a waste of resources. Long-term, the economic losses would merely flow to American taxpayers, which would then result in higher interest rates down the road; which would deprive capital to more worthy projects.

The housing boom was detrimental for the same reason. Sure, it employed a lot of people, but it caused more inflation in prices than productivity gains.

You have discovered that the 2000s were not real growth, but instead an illusion of growth due to monetary expansion

I've argued this for years. I even refused to buy a house during the boom because housing prices were so inflated versus rental prices.

The only person I can think of off-hand that I've insulted is Peter Schiff, who the "broken clock" analogy surely applies. He's a phony who pushes theories of American economic doom because it financially benefits his European and Asian investment businesses.

I've always maintained that the hyperinflationists are fighting the previous battle, as people tend to do. Not much different than how Europe attempted to fight ultra-nationalism with the Euro, after the sort of ultra-nationalism that caused two world wars had long ceased to be a threat.

I understand your angst in trying to find a more accurate price gauge than the faulty CPI measure, but real estate is a store of wealth, an income/spending provider for some, and a cost of living rolled up together.

If you include real estate prices, you cannot fail to include stock and bond prices in your master wealth/price deflator/inflator equation. Stock and bond prices have soared the last few years, with stocks doubling on average since March 2009. The "price" to buy an S&P500 company has risen +100% quickly. The total market cap of U.S. Dollar bonds (Treasuries, corporates, munis) and stocks are up about +40% in the last 30 months from the Lehman collapse low in late-2008. In reality, the INCREASE in wealth from financial assets has far outpaced the decline in real estate wealth.

If you measure inflation on a median income earner basis, not a mean average of all goods and services, the bottom half of our society are witnessing inflation increases ABOVE +10% the last 12-month period. America's standard of living has continued to plummet for the vast majority of U.S., despite a "growing" economy and soaring stock market wealth. Then the economy turns south again, from the sovereign debt madness.

I agree stagflation and/or hyperinflation are the most likely outcome into 2012. Few investors are properly prepared for our future. Energy and food prices will only fall with a major downturn in the economy at this stage. I listen to conversations around town from the average Joe realizing the price/cost of nearly every product and service is today rising rapidly. Inflation expectations are increasing now, and the FED is in quite a pickle, with few options to contain inflation. (You know I am in the hyperinflation camp at some point.)

The FED is actually working overtime to create inflation, by the way, dropping mountains of "free" money on banks and the Treasury bond market. Of course, nothing is free in life, and paybacks are a bitch. She is entering the arena as we speak.

There's one more way to eliminate the "investment" aspect of housing, without using rents. Look at new home prices.

Shiller showed that existing homes had an enormous price increase during the boom of the 2000's... he uses existing-home prices "to track the value of housing as an investment over time".

But, if you look at new homes, they had a much smaller price increase than existing homes. Using these prices would be more representative of the "inflationary" aspect of housing prices, while ignoring the "investment" side of it.

But, if you look at new homes, they had a much smaller price increase than existing homes. Using these prices would be more representative of the "inflationary" aspect of housing prices, while ignoring the "investment" side of it.

Actually, using new homes creates major problems, because you are no longer comparing two of the same good. With existing home prices, you are tracking pure cost of living increases.

How do you look at inflation for a new home, when every new home is different? You can't simply compare a 2000 sq ft home in Suburb A in 2008 with a 1800 sq ft home in Suburb B in 2011.

You mention that it was not a time of prosperity. But it was. There's certainly a subclass of people who benefited hugely during this time: people who came into the period owning real estate. I know more than a few folks who took money out of their homes - few hundred thousand or even up to a million - and put it in the stock market and pulled a triple or better, and then got out of everything - stocks, their homes and rental properties - when the handwriting was on the wall. Meanwhile taxes, on both cap gains and income, were at generational lows. A lot of these folks were couples in their mid-fifties who did well enough to retire. Now they lounge around in the resort community where I live, staying physically fit, visiting a lot of doctors, taking the boat out for a spin every so often, shepherding their kids through high school and college. They don't work; they live off the income from their capital and reinvest a good chunk annually as well.

This unearned wealth they accumulated was transferred to them as a result of the monetary policy you're about to analyze. Meanwhile, real wages stagnated, and rents eventually started to rise along with property values; the wealth was transferred from the workers/rentiers/have-nots to the haves.

I'm all about getting rich - that's great - but I'm not sure, socially, that this great experiment is going to turn out to have been a plus for America.

Excellent post. It has amazed me how much arguing there has been that "inflation" has been low in response to statements saying that it has been massive due to home costs and it has completely failed to account for the massive increase in housing.

You did an awesome job of showing how they managed such bogus accounting for massive inflation.

I just went and had a look at the article you referred to. Maybe what they should have done was had about 1/3 owner equivalent rent and 2/3rds by actual housing costs which approximately reflects what is really happening in the economy.

I have also been an advocate for doing away with allowable debt servicing being tied to the interest rates of the day. It should be fixed with allowances for differences in interest rates, and equity.